Market focuses on trade, yield curve inversion, recession outlook

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Sunday is Sept. 1. While that might not mean much to the municipal market in most years, this year it is the day 10% tariffs on more Chinese goods takes effect.

“There have been no signals from officials on either side that those new tariffs will be delayed,” said Marty Mitchell in the Mitchell Market Report. “Against this backdrop, we have to expect that pullbacks in the bond market will be shallow, if we get any at all.”

Trade has distracted bond traders from thoughts of rate cuts.

“Bond yields remained volatile due to United States-China trade headlines, overshadowing speculation about the extent of Fed rate cuts,” said Bill Merz, director of fixed-income at U.S. Bank Wealth Management. “The yield curve inversion remains an ominous sign, which has often foreshadowed recessions, though is a poor timing tool.”

While the Fed will likely cut rates 25 basis points at its September meeting, “we … view current market pricing of nearly three full cuts by the end of 2019 as somewhat optimistic, unless economic data deteriorates further,” Merz said. “We recommend investors maintain a portfolio with slightly below-benchmark duration. The flatness of the yield curve limits incremental yield investors would receive for extending into longer maturity bonds, though high-quality bonds with sufficient duration are critical to well-diversified portfolios.”

The trade war threatens the U.S. economic expansion, although a recession does not appear imminent, according to Darrell Cronk, president of Wells Fargo Investment Institute, and Paul Christopher, head of global market strategy. “Both sides raised tariffs only modestly on August 23, but raised the rhetoric substantially,” they write in an analysis. “Worse, there is no obvious way in sight for both sides to back down and save face.”

While the Fed is “likely to ease policy,” Cronk and Christopher question whether lower rates will matter. Lower rates may not spur borrowing if trade issues continue to slow global growth, and the possibility of “additional fiscal policy stimulus” has been raised. “While it is possible, sizable late-cycle U.S. fiscal stimulus would be somewhat unprecedented, difficult to fund and politically challenging to pass heading into an election year.”

On Wednesday, the spread between the 2-year Treasury yield and 10-year note, which has been bouncing in and out of inversion, inverted further. Edward Moya, senior market analyst, New York at OANDA, said that part of the curve “is accelerating its inversion to the lowest levels since the financial crisis. The deeper the inversion and the longer we stay inverted, the greater the calls will be for a sustained recession.”

Thomas Garretson, fixed income portfolio strategist at RBC Wealth Managemen, said forecasting the timing of recessions is a "largely pointless exercise. ” though he added, “it is fair to say the recession risks have risen materially in recent months.”

Comparing the upcoming months to a “whitewater rafting ride,” Scott Anderson, chief economist at Bank of the West Economics, adivised investors to “brace yourself for choppy water and maybe a number of rapids to maneuver around.” While no plunges are visible, the “many twists and turns” hide “what’s around the next bend in the river.”

Anderson expects quarter-point rate cuts in both the September and October meetings and two more in the first half of 2020.

“Even so,” he said, “all this extra monetary stimulus may not be enough to reverse a sharp economic slowdown that appears just ahead of us.”

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Monetary policy
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